WEALTH HEALTH: Volatile times call for creative investing strategies

We’ve all heard the old saw, “If you can’t beat them, join them.” In the financial services business, however, if you can’t join them the next step is to confuse them.

That’s the stage that the ETF business has gotten to as a recent spate of new-product announcements portend the next wave of industry evolution, as seemingly every major fund company that hasn’t had a big presence in exchange-traded funds is now looking at how to get there through active management.

As an investor looking at these choices, the difference between “new and improved” and “new and confusing” is pretty thin, so it’s important to greet the new products with a certain measure of skepticism.

First, let’s see what has been happening/changing in the world of exchange-traded funds.

Late in November, NextShares Solutions announced that its new “exchange-traded managed funds” would be available through US Financial Services, giving the latest development in funds – NextShares products had begun trading in early 2016 without much traction – a big step forward in visibility.

An ETMF – exchange-traded managed fund – technically is not what investors think of when they think ETF, and the difference is more than the extra word.

On the one hand, this is a structure that allows fund companies to put their actively managed strategies into a form that trades on an exchange, and has the potential to lower expenses and improve tax efficiency, two key hallmarks of ETFs. The flip side, however, is that the move is made without the daily mandatory transparency of an ETF, and that trades are made at the closing price of the day – like a traditional mutual fund – but with a premium or discount to that price to reflect that the sale was made intra-day, a convoluted system that many investors don’t seem to fully understand.

Days after the NextShares announcement, Vanguard filed registration papers on six new factor-based actively managed ETFs, funds like Vanguard U.S. Minimum Volatility or Vanguard U.S. Momentum Factor and more.

Vanguard, due to complicated legal issues, has long been the only fund firm that could effectively create “ETF shares,” allowing it to take its traditional funds and issue a special ETF class of shares for it. Still, Vanguard has also created ETFs from scratch – as it is doing here – but never before using a pure active strategy.

The rest of the industry creates ETFs from the ground up – though it can now work with NextShares to turn its existing mutual funds into ETMFs – and has been looking for ways to make a splash in the space, whether that means bringing over its active funds or coming up with new offerings. Behind the scenes, it is clear that the news announcements of product expansions are ready to zoom.

The offshoot: The fund industry will see an explosion of actively managed ETFs, which will rekindle the debate over active versus passive management.

It’s the wrong argument, all over again.

Active funds have a manager or team that makes all of the moves, typically attempting to deliver superior performance over time.

The problem is that active funds, historically, fail in those attempts. Managers can have runs of good performance but, saddled with comparatively high costs to pay for the decision-makers and their transactions, they tend to fall short over time.

Moving to the ETF platform – if it lowers costs and improves efficiencies -- could make active management more competitive.

Passive funds are built around index investing, whether it is the classic benchmarks like the S&P 500 or something newfangled that shifts or rebalances regularly, like the iShares Edge MSCI USA Quality Factor, which tracks a large/mid-cap index of U.S. stocks built around screens for earnings growth, high return on equity and more.

With the market riding higher for nearly a decade now, investors who have jumped on the index bandwagon have been paid handsomely. Active managers are up too, but the protection they theoretically offer during down markets – when a passive investor has strapped themselves to the index and will suffer any downturns – hasn’t been in evidence.

But the massive movement of money to passive funds has actually just been a shifting of the point where investors are paying for active management.

Many investors and advisers are actively managing their index-oriented funds, moving the cost of active management (both the fees and the potential erosion of performance) from the fund level up to the portfolio-construction level.

With countless studies showing how investors damage fund returns by shifting around, the question isn’t so much if you go active or passive, but whether you are buying a fund that you can be “inactive” with, meaning that you can hold it indefinitely regardless of management style, calmly accruing the benefits of whatever fund structure you choose.

Experts typically note that they would allow new funds to achieve critical mass – at least $50 million in assets – before investing; some proof of a new concept – a few years of real track record, rather than back-testing – should increase your comfort level. There’s no reason to rush into something new.

“Worry less about how a fund is structured, and more about how you can work with it and profit from it during times of volatility,” said Tom Lydon, editor of ETFTrends.com. “No matter the structure, you want to make sure you are getting the benefits of ETF investing – the low costs, the tax efficiency and more – with the long-term benefits you get from an investment you trust to work for you over the long run.”

Chuck Jaffe of Cohasset is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.

Chuck Jaffe of Cohasset is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.

Never miss a story

Choose the plan that's right for you.
Digital access or digital and print delivery.